Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
manage it. By law, shareholders are not allowed to interfere with the ordinary business—the day-to-day operations—of a corporation. But they elect representatives, the members of the board of directors, to oversee the management of the firm. The board of directors may be comprised of officers of the corporation or may include persons not employed by the corporation—referred to as outside directors.
It is not always clear just what constitutes the ordinary business of a corporation: Golden parachutes (attractive severance packages) for top management? Salary and stock options for management? Doing busi- ness with tobacco companies? Buying goods from companies employing underage workers?
6 Prior to this rights offering, Time Warner did attempt another offering whose terms were not in the best interests of the shareholders. Dennis E. Logue and James K.
Seward discuss the Time Warner rights offerings in detail in their article entitled “Time Warner Rights Offering: Strategy, Articulation and Destruction of Sharehold- er Value,” Financial Analysts Journal (March/April 1992) pp. 37–45.
FINANCING DECISIONS
EXHIBIT 16.1 The Value of a Time Warner Common Share and the Right to Buy a
Time Warner Common Share at $80 per Share
Source: Standard and Poor’s Daily Stock Price Record Any shareholder owning either $1,000 worth of the common stock
or 1% of the outstanding shares is permitted to introduce a proposal to
be voted on by shareholders. 7 To avoid having proposals that are inap- propriate—in the sense that they are really about ordinary business or simply a nuisance—the management may petition to the Securities and Exchange Commission (SEC) to remove a proposal from the proxy. In the past, the SEC has allowed corporate management to remove shareholder proposals that dealt with management compensation issues, but more recently has forced companies to include these proposals in the proxies.
A problem that became quite noticeable during the 1980s merger mania is that most large, institutional investors tended to vote as recom- mended by management and individual investors were, in large part, apa- thetic towards corporate issues. As both institutional investors and individual investors are forming coalitions to encourage shareholder partic- ipation in corporation issues, this situation is becoming less of a problem.
Another problem is that for most corporations, voting is not always confidential. It may be the case that management receives your votes and, if not pleased with how you voted, may contact you trying to per- suade you to change your vote. In many cases, shareholders and manag- ers of institutional investors have been pressured to vote in favor of the present management.
7 This requirement is set forth in the Securities Exchange Act of 1934, Rule 14a-8.
Common Stock
Still another problem is that if a shareholder proposal succeeds, the proposal is nonbinding. Management can simply ignore it. Complicating shareholders’ rights are provisions referred to as poi- son pills. Poison pill describes a provision that makes the target of a takeover offer unattractive. These provisions typically involve granting shareholders of the target firm special rights or privileges if the firm is the object of a takeover bid. Usually, the management of the target firm can negate the poison pill if they feel that the offer is in the sharehold- ers’ best interest.
An argument for these “pills” is that they allow the management of the target firm to negotiate the best price for the shareholders since the only way to avoid the costly poison is through management’s approval. An argument against these pills is that they discourage takeover bids that would have paid shareholders more than the current stock price for their shares.
Researchers have found that poison pills have a depressing effect on share price: Investors do not like these provisions. 8 Oddly, poison pills are often referred to as shareholder rights plans. Shareholder proposals represent a weak method of effecting change in a corporation. This is due to the apathetic nature of shareholders, the possibility of arm-twisting by management, and because these proposals are nonbinding. An alternative method of getting a corporation to change is to wage a proxy fight, gaining a voice in the corporation by getting seats on the board of directors. Usually, the board members elected each year are nominated by the current board members and run unopposed. In a proxy fight, an alternative slate of board members is nominated by someone interested in gaining representation on the board. And the battle begins.
A proxy fight pits current board members against the alternative slate, each slate vying for the votes, that is, the proxies, of the sharehold- ers. An example of a proxy fight is the one waged (and lost) by investors Carl Icahn and Bennet LeBow for control of RJR Nabisco Holdings in the spring of 1996. Icahn and LeBow initiated the proxy fight to force RJR Nabisco to spin-off Nabsico from the tobacco company. RJR Nabisco fought back and won, defeating the Icahn and LeBow slate by a 3-to-1 margin—and costing the RJR Nabisco $11 million (or 2 cents per share).
8 A detailed analysis of the different types of poison pills and how they affect share price can be found in Paul H. Malatesta and Ralph A. Walkling, “Poison Pill Secu-
rities: Stockholder Wealth, Profitability, and Ownership Structure,” Journal of Fi- nancial Economics (January/March 1988), pp. 347–376; and Michael Ryngaert, “The Effect of Poison Pill Securities on Shareholder Wealth,” Journal of Financial Economics (January/March 1988), pp. 377–418.
FINANCING DECISIONS
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
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